Sunday, January 04, 2009

I read the news today, oh boy

The New York Times in unusually readable today. First, parts 1 and 2 of Michael Lewis and David Einhorn's monster op-ed about the Wall Street Meltdown, which really should be read in it's entirety. Basically, it's a neat precis of how the Madoff Ponzi scheme is, in fact, just a few degrees removed from the criminality embedded in the structure of American capitalism. Yes, it's hard to read it without coming away sounding like a Marxist.

Up next: from the Magazine, an article on how much faith the market placed in what amounted to a jumped-up spreadsheet.

The answer the bank’s quants had come up with was Value at Risk. To phrase it that way is to make it sound as if a handful of math whizzes locked themselves in a room one day, cranked out some formulas, and — presto! — they had a risk-management system. In fact, it took around seven years, according to Till Guldimann, an elegant, Swiss-born, former JPMorgan banker who ran the team that devised VaR and who is now vice chairman of SunGard Data Systems. “VaR is not just one invention,” he said. “You solved one problem and another cropped up. At first it seemed unmanageable. But as we refined it, the methodologies got better.”...

JPMorgan later spun RiskMetrics off into its own consulting company. By then, VaR had become so popular that it was considered the risk-model gold standard. Here was the odd thing, though: the month RiskMetrics went out on its own, September 1998, was also when Long-Term Capital Management “blew up.” L.T.C.M. was a fantastically successful hedge fund famous for its quantitative trading approach and its belief, supposedly borne out by its risk models, that it was taking minimal risk.

L.T.C.M.’s collapse would seem to make a pretty good case for Taleb’s theories. What brought the firm down was a black swan it never saw coming: the twin financial crises in Asia and Russia. Indeed, so sure were the firm’s partners that the market would revert to “normal” — which is what their model insisted would happen — that they continued to take on exposures that would destroy the firm as the crisis worsened, according to Roger Lowenstein’s account of the debacle, “When Genius Failed.” Oh, and another thing: among the risk models the firm relied on was VaR.

Nicholas Nassim Taleb comes of as a pompous ass, which has a ring of authenticity about it. But if you're a fan of his books, you should still enjoy the article.

I consider it especially ironic that these red-blooded giants of capitalism, the type of person who laughs at the predictions of a computer model like Earth II when it's used by the Club of Rome, managed to drive us all over the cliff by making their precious model in to the Godhead. Because, y'know, it's different when they do it.

Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said: "The interbank market could freeze up, and one could well have a full-blown financial crisis."

Two years later, that's essentially what happened.

Many of the big names in Jackson Hole weren't ready to hear the warning. Former Treasury Secretary Lawrence Summers, famous among economists for his blistering attacks, told the audience he found "the basic, slightly lead-eyed premise of [Mr. Rajan's] paper to be misguided."

That's right, a University of Chicago economist was mocked for being insufficiently pro-capitalist because he was trying to ring the warning bell. Also, the attendees at Jackson Hole remarked that the Pope was insufficiently Catholic, and that bears are insufficiently pro-woods-shitting.